Please forgive the history lesson/re-hash, but we’ve all heard the story. It was the night of April 18, 1775 when Paul Revere took his famous “midnight ride” to warn the colonists that ‘the British are coming, the British are coming!’ In reality, what he actually said was ‘The Regulars are out!’ But the first quote sounds better so we’ll stick with that. Having learned that the colonists were storing their munitions in Concord, the British planned a march and assault to secure said munitions and to send a strong message. Revere rode through town after town warning sleeping colonists so they could take up arms.
Flash forward to 2015. There seems to be a Revere-esque warning being sent through the financial planning industry. Is it the Brits? Again? Heck no, we love those people and we’ve obviously worked through our differences. After all, they’ve since brought us The Beatles, James Bond, Wimbledon, and The Jaguar. We’re square as far as I’m concerned. What then are financial advisors being warned about? The “Robo Advisor”! Apparently, the robots are coming and they have plans to make a large footprint in the financial advisory landscape.
Paul Revere’s ‘midnight ride’ began that fateful night with a message delivered via two lanterns in the steeple of the Old North Church in Boston. The message delivery system was ‘one if by land, two if by sea’. Well, buckle up, because the Robots are coming and the new system will be ‘one if by Google and two if by Bing!’ Robo Advisors are online financial advisory services that are gaining headlines for their close ties to Silicon Valley, low costs, and simplicity.
How do Robo Advisors work? From a high level, they work just as any investment advisory relationship should. You provide some information about your existing portfolio and its holdings and answer some questions about yourself (age, risk tolerance, etc.) and the Robo Advisor then ‘optimizes’ your portfolio. What does ‘optimize’ mean? Optimization uses asset allocation software that attempts to make your portfolio as efficient as possible from a risk/reward standpoint. The chassis of many of these programs is largely built using Harry Markowitz’s 1990 Nobel Prize winning study which brought us the “Efficient Frontier”. Any portfolio falling on the Efficient Frontier is considered to be efficient, in the sense that it maximizes your expected return for a given level of risk. I visited one of the larger Robo Advisor’s sites to find out more. The site outlined the 4 ways that they boost their clients’ portfolio returns. Please note, the assumption here is that a prospective Robo Advisor customer has been managing their own money in a portfolio of costly, actively managed, and underperforming investments. Here are the four ways that they claim to improve portfolios and my corresponding thoughts:
1) Use of passively managed investments: Passively managed investments are inexpensive when compared to the assumed hypothetical prospective client’s expensive, actively managed investments. My thoughts? This is great, I strongly support the use of passively managed investments to lower portfolio costs. Lower costs can increase the efficiency of a portfolio which can allow it to grow larger over time. This is a no-brainer to me. Check.
2) Better Diversification: The use of asset allocation software and the placing of clients’ portfolios on the Efficient Frontier. My feedback? Another no-brainer. If investors are not sufficiently diversified, they should be. While there is no guarantee that a diversified portfolio will enhance portfolio returns, The Efficient Frontier is an effective tool. Check.
3) Use of Rebalancing: Rebalancing is the process of periodically bringing your portfolio’s allocation, or your “pie”, back in line with its original proportions. This effectively enables you to buy low/sell high (at least relatively) though it should be noted that rebalancing can cause tax consequences. Does rebalancing make sense? Absolutely and check.
4) Improved Investor Behavior: Generally speaking, investors are their own worst enemy. Study after study shows that they have a natural inclination to buy and sell assets at exactly the wrong time. The cause? One word: Emotions. This is the basis for the well-respected science of Behavioral Finance. Is it beneficial (at least theoretically) to take buy/sell/management decisions out of the hands of the average emotional investor? Absolutely. Check and check.
I know what you’re thinking: so what’s your problem with Robo Advisors? It seems as if I agree with everything that they’re doing. Maybe the robots are taking over! Should I apply for a job at Starbucks? The fact of the matter is that I have no issue at all with the robots, and in fact, I believe that they can serve a healthy function for certain groups of investors, largely those who are just beginning to invest with small capital bases. I also believe that they present an enormous threat to the stubborn, lazy, and uninformed amongst my colleagues.
A wise man once said in presenting a product or service to a customer ‘this product/service is great, it can be newer, cheaper, or better. Pick two.” Robo Advisors are indeed newer (although nothing that they do is actually new), they can certainly be cheaper, but I’m not convinced that they are ‘better’ per se. As a bit of housekeeping, let’s begin by closing the loophole for those who may be tempted to claim that Robo Advisors are newer and better because they’re cheaper! J It’s my blog and I have elected myself czar of loopholes. It’s closed.
My best description of the benefits of one of these services is that they are cheap and simple. A cheap and simple investment portfolio appears to be all you’d ever need during low volatility bull runs like the one we’ve seen over the past few years, but not so much when volatility spikes and the winds pick up. You know that awesome $3 floaty tube that you bought at Walgreens? You remember, the one you cruise around on in your backyard pool while you drink a margarita? Ahhhhh, so pleasant, so relaxing………a high performance floaty tube, so cheap, so simple. Now, let’s cut to one of those ugly, 3 AM scenes from the show The Deadliest Catch where one of those king crab fisherman gets tossed over the side of the boat into the coldest, angriest sea you could ever imagine………..I really hope that guy has more than your Walgreens floaty on when he goes over!
We know what a Robo Advisor can do: lower cost, add diversification, rebalance, and generally take the decision making out of your hands. Here is a non-all-inclusive list of some critical functions that the robots don’t, and in some cases can’t, perform:
· They have no ability to talk a rattled investor of the proverbial ledge when the markets are under stress. As a bit of a health warning: discount the importance of this dynamic at your own risk.
· They will not implement any type of technical overlay strategies (i.e. momentum or relative strength-based), which may provide the opportunity to sidestep large drawdowns within a portfolio.
· They will not implement any true alternative investment strategies within portfolios. These strategies are far from cheap and there is a lot of education and hand-holding that goes into implementing them within retail client portfolios. Education and hand holding activities are not exactly a robot’s strong suit.
· Robo Advisory firms are obviously new age and tech-focused. They tout the intuitive nature of their programs and the ease of enrollment. What happens when, not if, the markets get clobbered and a new, shiny, ‘efficient’ portfolio is down (hypothetically) 30% vs. a client’s old ‘inefficent’ portfolio that would have been down (hypothetically) 37%? I’m assuming that it’s equally as easy and intuitive to log-on the Robo Advisor’s site and hit the ‘sell’ button as it is to log in and enroll in the program. Ease of use cuts in both directions and in my mind, this doesn’t solve the problem of people freaking out and making bad investment decisions. These firms tout their ability to mold ‘improved investor behavior’, which is a polite way of saying that they can save a client from themselves and their inclination toward poor investment decisions. This sounds great on its face, but I question whether this will hold up under real and unrelenting market stress (think October of 2008). Creating a website that runs asset allocation software for clients does not exactly crack the code of Behavioral Finance, and in fact, it may actually perpetuate many of the classic ‘cognitive errors’ and ‘emotional biases’ defined by Behavioral Finance (beyond the scope of today’s post).
What does all of this mean for my industry? I believe that the robots are a legitimate threat to those in my industry who are doing little more than these new services provide but charge significantly higher fees (think welder at the Ford plant who was replaced by a robot). Unfortunately, this contingent of advisors represents a large portion of the industry and this presents an opportunity for the robots. It’s tough for those advisors, but change is being forced by technology and it is what it is. Those that do not adapt and legitimately increase their value proposition and money management skills may soon find themselves serving their lunch to a robot. ‘beep, boo, beep, beep’. That’s robot for ‘watch your back’.
By: Andrew Gonski
The opinions voiced in this material are for general information only
and are not intended to provide specific advice or recommendations for any
Investing involves risk including loss of principal. No strategy assures success or protects against loss.